For many people, the idea of starting a savings and investment plan can be rather intimidating and unpleasant. Most people simply don’t how or where to invest. This explains why such a large percentage of the global population is not financially prepared when they reach the age of retirement.
Saving and investing does not have to be a difficult experience. In fact, it can become a rewarding and enjoyable endeavor if you develop a simple plan of action. Let’s review some of the basic steps you can follow in order to become a successful investor.
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Tip #1 – Pay yourself first
This is probably the most important rule to follow if you want to become a successful saver and investor. “Pay yourself first,” means that you should always place a fixed percentage of your salary in an investment account. For example, let’s assume that you are paid two times per month by your employer. You should immediately place a fixed percentage of your paycheck into a savings or investment account. In fact, this process should occur automatically using an electronic transfer of funds.
Of course, an important question is, “How much should I transfer to my savings account?” That’s a difficult question to answer because it depends on a number of different factors. The simple answer is, you should transfer to your savings account as much as can comfortably afford. A more accurate way to answer this question is to create a budget, which is a list of all the items you spend on a monthly basis. The budget will give you an idea of how much money you can place in your savings account.
In terms of percentages, there is no “one size fits all” amount that savers should place in their accounts on a monthly basis. The general consensus among professional financial advisors is that we should attempt to save 10% to 15% of our annual salary (based on the fact that most people work 30 to 40 years before they retire).
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A more appropriate way to calculate your savings percentage is to determine your “replacement rate.” In layman’s terms, the replacement rate is the percentage of your salary that you’ll receive in retirement benefits after you stop working. As an example, let’s estimate that your annual salary is $100,000. Upon retirement, you receive $45,000 in annual benefits from your former employer. Therefore, your replacement rate is 45%. Based on years of economic research and retirement studies, the average retiree needs a replacement rate of 70% in order to comfortably retire. In our example, you would need to save 25% of your annual salary in order to match the appropriate replacement rate of 70% (70% – 45% = 25%).
In our example, age is not factored into the equation. The earlier you begin saving for retirement, the less money you will need to place in your savings accounts on a monthly basis. The replacement rate does not provide a perfect answer. However, it does give us a good starting point.
Tip #2 – Diversify your investment account
Saving 10% to 15% of your annual salary is a great first step in preparing for retirement. However, it’s equally important to properly invest your money. One of the biggest challenges among new savers and investors is how and where to invest.
There are four types of investment categories for investors to choose from. The list includes cash, stocks, bonds, and alternative assets. How much should you invest in each category? The answer depends on several different variables such as age, income level, investment experience and tolerance for risk. However, a good solution would be to invest an equal amount of your account into each category. This is known as diversification.
Diversification is a conservative approach that leads you to divide your investment account equally into each category. One of the worst mistakes you can make is to place all of your investable assets into a single category. This could turn out to be a recipe for disaster. Always remember the old saying, “Don’t put all of your eggs in one basket.” This is particularly true in the world of investing.
The safest category is cash, which is basic savings account at a bank. Your funds are certainly well protected in this category because there is virtually no risk of loss. Unfortunately, the rate of return is extremely low; typically less than 1%.
The most volatile and riskiest category is alternative assets. This would include items such as commodities, real estate, precious metals, rare artwork, and rare coins. Although it’s difficult to pinpoint an exact rate of return, historical results indicate that alternative assets (taken as a group) produce an average annual return of 15%.
Stocks and bonds fall in the middle in terms of the annual rate of return. Based on long-term performance, stocks yield a 10% annual return. Bonds typically generate a 5% rate of return over time.
Once again, the key to success is diversification. Over the long run, your results will improve dramatically by investing equally in each category.
Tip #3 – Create an emergency fund
As we discussed earlier, starting a long-term savings plan is a critically important part of becoming a successful investor. However, there are a few things you should accomplish before you implement a new savings plan. One of the first things you should do is create an emergency fund.
What is an emergency fund and why is it so important? An emergency fund is used to pay your monthly living expenses during periods of unemployment or illness. Very often in life, unexpected events occur which interrupt our daily income stream. The vast majority of these events are temporary, lasting from a few weeks to a few months. An emergency fund (also known as a rainy day fund) can help you survive from a financial standpoint until you are able to begin working again.
How much money should you keep in an emergency fund? Although there is no perfect answer, a good rule of thumb would be to maintain a balance equal to six months of living expenses. This should be enough to get you through difficult financial times.
Your emergency fund should not be invested. Instead, the money should be placed 100% in cash. It’s never a good idea to place your emergency fund in a speculative investment such as stocks or alternative assets. Remember, an emergency fund should be immediately available when you need it. Therefore, the money should always remain in a cash account.
Tip #4 – Eliminate credit card debt
As you know, credit card debt carries an incredibly high-interest rate. It’s probably the worst form of debt. For those who maintain a high credit card balance, it can very difficult to eliminate the debt. Very often, it takes years to pay off the entire balance.
Under no circumstances should you begin a savings and investment plan until you completely eliminate all credit card debt. In fact, it would be best to dispose of all high-interest rate debt before initiating a long-term investment program.
Generally speaking, a well-diversified investment account will generate a 6% to 8% annual rate of return over the long run. If your credit card debt has an interest rate higher than 6%, it makes absolutely no sense to implement a savings plan. Your top priority should be to dispose of the debt.
Tip #5 – Start a college savings plan
This tip is only for those who have children.
As you know, the cost of a college education is completely out of control. Since 1990, the average cost has increased by 406%. The only way for parents to confront this huge expense is to initiate some type of college savings plan. Of course, it’s always best to start early.
As we discussed in Tip #4, it’s never a good idea to begin a savings plan until all credit card debt has been erased. This includes a college savings plan. Eliminate the debt first and then start saving for your children’s college education.
A college savings plan is considered a long-term project, very similar to your investment program. Therefore, a good approach would be to diversify the investment into stocks, bonds, and cash. Investing for college should be slightly more conservative than investing for retirement. Accordingly, it’s probably a good idea to avoid alternative assets. As you know from our discussion, alternative investments carry the greatest amount of risk, probably not suitable for a college savings plan.
Tip #6 – Avoid paying high fees with your investment program
Here’s a fact: The overwhelming majority of investors have no idea the amount of fees they are paying in regards to their investment accounts. This is particularly true when it involves investments in mutual funds.
Without going into great detail, all mutual funds carry a fee. After all, that’s how mutual fund companies make money. They charge a fee to the owners of their mutual funds. However, the fees can vary dramatically from one mutual fund company to the next.
If you own a mutual fund in your investment program, it would be a good idea to review the mutual fund prospectus. Find out exactly what type of annual fees are being levied against your account. If you are paying over 1% per year, you are probably paying too much. In terms of mutual fund fees, Vanguard is the leader within the mutual fund industry. They have the lowest fees among all mutual fund families. Two other good candidates would be Fidelity and T Rowe Price.
Tip #7 – Reduce or eliminate unnecessary monthly expenses
As we discussed in Tip #1, it’s always a good idea to create a monthly budget. This will give you an idea of where your money is being spent. Take a good look at your budget. Most likely, you will find items that can easily be reduced or eliminated. These items would include such things as dining out, buying unnecessary clothing, purchasing a morning coffee on your way to work, excessive online shopping, golfing on the weekends and paying for overpriced monthly subscription services.
By reducing your monthly budget, you can increase the contributions to your investment plan or help pay off high credit card debt. Make a commitment to examine your spending habits. You will probably discover a few things that can be discarded from your daily routine.
Tip #8 – Establish investment goals
Maintaining a successful investment plan is a long-term process. It’s a marathon, not a sprint. Very often in our lives, we can lose focus on long-term projects. Why? Because it’s very difficult to stay motivated for extended periods of time. The best way to sustain a multi-year project is to establish goals and objectives.
Starting an investment plan is a great first step towards achieving financial security. However, the plan must be successfully maintained for 20 to 30 years (or longer). The best way to stay focused for 30 years is to set obtainable goals throughout the life of the project. For example, a good idea is to set yearly goals for your long-term investment plan. This will help you concentrate on a 12-month goal instead of a 30-year goal. It makes the entire process much less stressful and overwhelming.
Many people these days struggle with money. They have a poor relationship with money. Why? Because they are not properly educated. By following these 8 tips, you can enjoy a better relationship with your money and maybe one day reach the ultimate goal of financial freedom.
Strategies to become a successful investor
- Automatically place a percentage of your paycheck in a savings plan
- Start a savings and investment plan as soon as possible
- A good rule of thumb is to place 10% to 15% of your annual salary in a savings plan
- Determine the appropriate savings rate by calculating your replacement rate
- There are four main investment categories (cash, stocks, bonds and alternative assets)
- Successful investing requires diversification
- An emergency fund should cover six months of living expenses
- An emergency fund should always be invested in cash
- Eliminate credit card debt before you start an investment plan
- If you have children, start a college savings plan
- Eliminate credit card debt before you initiate a college savings plan
- Avoid paying high mutual fund fees by examining the mutual fund prospectus
- Reduce or eliminate unnecessary spending habits
- Develop investment goals on a yearly basis
This wonderful article is from one of our guest contributors.
